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NBR’s rate correlation with real economy rates is at best spurious

One theme I keep repeating is that the credit channel is not working in Romania ans will not be working as long as the central bank is focused solely on the exchange rate.Google Translate Tonight the NBR put forward via Deputy Governor Mr. Popa another piece of evidence to show that credit channel is working and what we are seeing is just a lag effect. The evidence in question is the interest rate for new credit which according to the NBR has fallen by 0.40% in response to the 0.75% cut in the key policy rate.

Let’s see what the evidence shows. The graphs below show for both households and corporates the interest rates for existing and new credit.

There are few things coming out from those graphs. The most important is that the recent drop in rates for new credit can hardly be attributed to a more relaxed monetary policy. The data shows that for households rates for new credit were lower in December 2010 or July 2011 than they are today. At that time the key policy rate was 6.25% while today is 5.5%.

Furthermore very important to note that the average rate for new credit over the last 12 months when the key policy rate was higher, still for households, was 12.45% while today is at 12.66%. Thus is very hard to prove that decrease in new credit rates for the last two months has anything to do with a lower key policy rate. For those interested the same is true for rates regarding new credit for corporates.

Next, please not that the spread between new and existing credit for corporates is much smaller than the one for households. This tells me that the market for corporate credit is much closer to a competitive one than the one for household credit.

A working credit channel is paramount for any central bank. It is the main channel through which monetary policy gets to the real economy. To work it needs a proper framework. Unfortunately the Romanian central bank has undermined this channel when it started to focus primarily on the exchange rate and use the monetary base as instrument. In this framework the key policy rate is irrelevant and any correlation between this rate and the ones for credit is at best spurious.

Here there is questioned that the money multiplier model really works, but actually that credit expands through the willingness of banks to lend first and then look for reserves. The central bank accomodates the new demand for liquidity by increasing the monetary base. (I have also seen also a similar theory called “risk”-cycle or “leverage”-cycle, in which interest was only a part of the business cycle, the other beeing collateral. )

@Andy
Very quickly.
The money multiplier works but not right now and not the same in all economies. For example in developing economies I believe that credit expansion has more to do with the size and health of the banks’ balance sheet than with the monetary policy.

I think Gavyn Davies does a nice description of what we are actually seeing in the financial markets today. It also explains why in Romania banks are more than happy to pocket the better margin offered by the NBR without extending more credit. In the same time Romania is not in the situation of other countries which have been increasing the monetary base since 2008, sometimes doubling it. We know it has not been inflationary there yet mainly because banks and governments are keeping the extra cheap cash. In Romania in the absence of extra liquidity the existing one is made more expensive because both the government and banks are hoarding it. That is why the interbank market has converged to the short end of the curve and it is very sensitive to any small changes in the stock of money, i.e. volatile. An increase in the monetary base, at least to the level of 2009 will “calm” the waters and lower the price of money that is available int eh private sector. The extra liquidity will not get immediately tot the real economy. we observe this in December 2011 and January 2012 when the liquidity injected by the NBR does not show up no the money market but it does lower the price of money (albeit very short term).

Now, I firmly believe that over medium term doubling the monetary base will create inflation even hyperinflation. AS we can see financial markets are now hooked on cheap liquidity and cannot function otherwise. But after the de-leveraging process banks will lend again. It is then that the extra liquidity available today , not in Romania, will create problems.

The western world is in a “liquidity trap” or in some strange state where the banks are not willing to lend although enough excess reserves. A dumb questions from my side: why does not the central bank loan directly to the economy (or at least some sectors of it.)? Why do quantitative easing and buy long term government bonds, or toxic assets (and by doing this increase central bank balance sheet risks), and why not instead stimulate directly the economy ?

@Andy
There are people who believe this could be a solution. No me though. I think we would open the door a practice for which we have no idea how it would impact us in the long run. I mean there is moral hazard. Then there is the issue of what assets to buy. Furthermore what if the central bank makes a loss from buying those assets? These are just few of my immediate concerns. There are more regarding, transparency, credibility the implications of such a policy rule for output and inflation volatility. etc.
My view in general is that the success of a central bank or government is measure by how little we feel their presence and not by how much they rule our life.